Share repurchases and scrip issues - EPS, gearing, and marke...

Learning Outcomes

After studying this article, you will be able to explain and compare the effects of share repurchases and scrip issues on earnings per share (EPS), gearing, and the reaction of the stock market. You will identify how these corporate actions affect financial statements and key ratios, interpret their implications for shareholders, and anticipate potential exam questions related to these topics.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the impact of changes to a company’s capital structure and share capital on key financial ratios and market expectations. In particular, revision should focus on:

• The accounting implications and reasons for share repurchases (buybacks), scrip issues, and bonus issues
• The effect of capital structure changes on EPS and gearing ratios
• The possible reaction of the stock market to these transactions
• The distinction between scrip issues and share repurchases
• The effect on total shareholder wealth and the considerations for shareholders

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the immediate impact of a share repurchase on a company’s number of shares in issue and its reported EPS, assuming profit remains unchanged?
2. Which of the following best describes a scrip issue? a) The company repurchases shares from shareholders b) The company issues new shares for cash to selected investors c) The company issues new shares free to existing shareholders, proportionally d) The company pays a cash dividend in place of shares
3. True or false? A share repurchase will almost always increase financial gearing, assuming the buyback is financed from cash or new debt.
4. Briefly explain how the stock market might react to a large scrip issue.

Introduction

Share repurchases (buybacks) and scrip issues (bonus issues) are important corporate actions that affect the capital structure of a company and can change key measures such as EPS and gearing. These actions also influence the behaviour of investors and can impact the company’s share price. Understanding these effects and the motivations behind them is key for ACCA Financial Management candidates and often tested in exams.

Key Term: share repurchase
The process by which a company buys back its own shares from the market, reducing the total number of shares in issue.

Key Term: scrip issue
The free allotment of additional shares to existing shareholders based on their current holdings, also known as a bonus issue.

Key Term: earnings per share (EPS)
A financial ratio calculated as profit after tax attributable to ordinary shareholders divided by the number of shares in issue.

Key Term: gearing
The relationship between a company's debt (or other forms of fixed interest capital) and its equity capital, measuring financial risk.

Overview of Share Repurchases and Scrip Issues

Both share repurchases and scrip issues alter a company's equity structure—but in opposite ways. Share repurchases reduce the number of shares and usually distribute cash to shareholders, while scrip issues increase the number of shares with no cash involved.

Share Repurchases

Share repurchases (buybacks) take place when a company uses available cash or new borrowings to purchase its own shares. This leads to:

• Reduction in the number of outstanding shares.
• An immediate increase in EPS if profits remain unchanged, as total profit is now spread over fewer shares.
• Possible change in gearing ratios as cash is reduced and, if debt is used, borrowings may rise.
• Change in dividend payments, as future dividends will be spread over fewer shares.
• Potential increase in share price if the market views the buyback as a signal of confidence or as returning surplus cash not needed for investment.

On the other hand, the company's total equity falls, and if reserves are used, retained earnings also decrease.

Impact on EPS

Because the number of shares falls, if profits remain unchanged, EPS will generally rise. However, this must be interpreted carefully:

• The increase in EPS may not reflect increased profitability, but an accounting adjustment.
• If the buyback is financed by new debt, higher interest expenses in the future may reduce profit after tax.

Impact on Gearing

Share repurchases can increase financial gearing (debt to equity):

• Using cash reduces equity.
• Borrowing to finance the buyback increases debt.
• This may increase financial risk and the required return for shareholders.

Market Reaction

The market may react positively if the buyback is seen as a sign that management is confident in the company’s prospects or believes the equity is undervalued. However, the use of financial resources to repurchase shares rather than invest may raise questions if growth opportunities exist elsewhere.

Scrip Issues (Bonus Issues)

A scrip issue involves the company issuing new shares to existing shareholders for free, in a set ratio. This does not raise new funds or affect total equity—reserves are simply transferred to issued share capital.

Effects on EPS

Scrip issues increase the number of shares in issue, so—assuming profits remain unchanged—EPS will fall. However, each shareholder's proportion of the company stays the same.

Effects on Gearing

Scrip issues do not affect the company’s cash, borrowings, or total equity, and therefore have no direct impact on gearing.

Reasons for Scrip Issues

• To increase the number of shares and reduce the market price per share, improving liquidity.
• To signal confidence and reward shareholders, though no new value is created.
• To comply with listing requirements (some exchanges require a minimum number of shares).

Market Reaction to Scrip Issues

In theory, a scrip issue should not change the total value of the company or shareholders’ proportional ownership, as each share is worth less, but shareholders hold more. Share price may fall in proportion to the new number of shares. However, increased liquidity or improved share price affordability may attract new investors.

Comparison: Share Repurchase vs Scrip Issue

Worked Example 1.1

A company has 10 million shares in issue and $2 million profit after tax. It uses $5 million from its cash reserves to repurchase 1 million shares at $5 each.

Required: Calculate the EPS before and after the buyback, and discuss the change in gearing if the company had $7 million in equity and $3 million long-term debt before the buyback.

Answer:
Before the repurchase:

• EPS = $2m / 10m = $0.20
• Gearing = $3m debt / $7m equity = 43%

After buying back 1m shares:

• Shares left: 9m
• EPS = $2m / 9m = $0.222
• Equity falls by $5m used for buyback: new equity = $7m − $5m = $2m
• Gearing = $3m debt / $2m equity = 150%

Comment: EPS appears to increase, but mainly due to lower number of shares. Gearing rises markedly, indicating increased financial risk.

Worked Example 1.2

A company declares a 1-for-4 scrip issue. It has 4 million shares in issue and profit after tax of $800,000. What is the EPS before and after the scrip issue? What will happen to the share price, assuming total equity remains unchanged?

Answer:

• New shares issued: 4m × 1/4 = 1m (Total = 5m shares)
• EPS before = $800,000 / 4m = $0.20
• EPS after = $800,000 / 5m = $0.16
• In theory, share price falls by 20%. Shareholder percentage ownership is unchanged.

Exam Warning

Do not assume that an increase in EPS from a share buyback means the company is more profitable. Always consider how profit, equity, and the number of shares have changed, and check the impact on key ratios including gearing.

Revision Tip

In exam questions, clearly state whether company actions such as repurchases or scrip issues have any real effects on shareholder value, or if changes are cosmetic (affecting only accounting ratios, not actual wealth).

Summary

Share repurchases reduce the number of shares and often increase EPS and gearing, with possible positive market reaction if well-signalled. Scrip issues increase the number of shares, dilute EPS, but do not affect gearing or shareholder wealth. Both actions have different motivations and effects on key ratios and shareholder perception.

Key Point Checklist

This article has covered the following key knowledge points:

• Define share repurchases and scrip issues and distinguish between them
• Explain the impact of share repurchases on EPS, gearing, and market reaction
• Explain the impact of scrip issues on EPS, gearing, and market reaction
• Evaluate how these actions affect total shareholder wealth and shareholder ownership
• Interpret exam questions requiring calculations and explanations of changes to EPS and gearing
• Identify when apparent improvements in EPS may be misleading

Key Terms and Concepts

• share repurchase
• scrip issue
• earnings per share (EPS)
• gearing